No Black Swans in Financial Markets?

My friend Nassim Taleb gave testimony this week to the House Committee on Science & technology. The topic was financial modeling and value-at-risk, and his fellow panelists included Chris Whalen and Rick Bookstaber, among others. It is interesting that while all agree on some broad principles about the perils of models in markets, both Whalen and Bookstaber were dismissive of the idea of "black swans" in markets. (To be fair, I think Taleb has said that the crisis was no black swan — it was eminently foreseeable — so maybe this is all hair-splitting about whether anything in finance is a black swan.)

We take a different view. We don’t actually believe there is such a thing a a “Black Swan.” Our observations tell us that a more likely explanation is that leaders in finance and politics simply made the mistake of, again, believing in what were in fact flawed models and blinded themselves to what should have been plainly calculable innovation risks destined to be unsustainable. Or worse, our leaders in Washington and on Wall Street decided to be short sighted and not care about the inevitable debacle.

There is a constant theme in [articles about the crisis], invariably including a quote from Nassim Taleb, that quants generally, and quantitative risk managers specifically, missed the boat by thinking, despite all evidence to the contrary, that security returns can be modeled by a Normal distribution.

This is a straw man argument. It is an attack on something that no one believes. Is there anyone well trained in quantitative methods working on Wall Street who does not know that security returns have fat tails? It is discussed in most every investment text book. Fat tails are apparent – even if we ignore periods of crisis – in daily return series. And historically, every year there is some market or other that has suffered a ten standard deviation move of the "where did that come from" variety. I am firmly in the camp of those who understand there are unanticipatable risks; as far back as an article I coauthored in 1985, I have argued for the need to recognize that we face uncertainty from the unforeseeable. To get an idea of how far back the appreciation of this sort of risk goes in economic thought, consider the fact that it is sometimes referred to as Knightian uncertainty.

Is there any risk manager who does not understand that VaR will not capture the risk of market crises and regime changes?